Dr. Jonathon Adams-Kane is a research economist with the international finance and macroeconomics team at the Milken Institute. His research is mainly on international capital flows and financial stability, with a focus on analyzing structural changes in the international financial system, how crises spread among countries through international banking, and...

Jakob Wilhelmus is an associate director in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows, and investment. Concentrating on market-level information, his work focuses on identifying and analyzing financial data to produce a better understanding of the behavior and underlying structure...

In the wake of the 2008 global financial crisis and ensuing regulatory reforms, U.S. banks dramatically altered their sources of funding. Banks have reduced their reliance on non-deposit sources for funding, which now comprise only 13 percent of bank liabilities, compared with more than 30 percent 10 years ago. However, banks have increased their funding from FHLBs, which began to rise rapidly in 2012 and roughly doubled in the five years leading up to 2017.

This shift in bank funding sources may have been a consequence of policy changes to liquidity requirements and the money market fund (MMF) reforms designed to strengthen financial stability. Both of these regulatory changes effectively encouraged banks to obtain safer funding with advances from FHLBs instead of relying on other non-deposit instruments such as repurchase agreements.

The overhaul of rules for MMFS, implemented in 2016, caused businesses seeking to maintain the certainty of a given price for their MMF shares to reallocate roughly $1 trillion from prime to government funds.[i] The reallocation reduced demand for assets eligible to be held by prime funds but not government funds, e.g., commercial paper (CP). The sudden growth of government funds stimulated demand for notes issued by FHLBs, classified as agency debt, and thereby lowered the cost of funds. Consequently, FHLBs have increased their issuance of obligations and their advances to banks, substituting for banks’ direct issuance of CP (See Figure 1).

Source: AuthorsNote: The set of instruments in the figure is simplified; see paper.

FHLB advances to banks grew by 21 percent over the last three quarters of 2016, and stood at just over $500 billion at the end of the year. This growth was accounted for by medium-sized as well as large banks, just as one might expect given the twofold mechanism by which the new rules for MMFs affected bank behavior: First, the reforms depressed the market for CP, a common source of financing for medium-sized as well as large banks. Second, they stimulated demand for FHLB obligations, so FHLBs could raise financing more cheaply and then lend to banks—irrespective of bank size—at attractive interest rates.

The prominent funding role for FHLBs was the combination of two effects: the new rules for MMFs and a previous trend among larger banks of using FHLB advances to purchase high-quality liquid assets (HQLA) to meet regulatory liquidity requirements. FHLB advances are typically backed by mortgages as collateral, so any HQLA purchased can remain “unencumbered” (i.e., not tied up as collateral), thus counting in the liquidity coverage ratio. Advances also are a closer maturity match for typical holding periods of HQLA, as they are generally longer-maturity than alternatives such as repo and federal funds. Thus, they can enhance the liabilities side of the balance sheet to meet liquidity requirements, as well as the assets side. The Federal Housing Finance Agency identified new liquidity requirements under the Basel III framework as the key factor behind the resurgence of FHLB advances. The surge in FHLB advances from 2012 through 2014 corresponds well with the timing of the rollout of more stringent (Dodd-Frank) liquidity requirements for large banks.

The underlying (regulatory) reasons for the 2012-2016 increase in FHLB advances are in stark contrast to the drivers of a surge in advances that occurred from 2006 to 2008. At that time, highly leveraged banks turned to FHLBs to replace other sources of short-term funding as they became scarcer and more costly. This has been described as the FHLBs playing a “lender of next-to-last resort” role. During this period, and into 2009, the large banks’ collective share of FHLB advances grew, but this was largely due to the disproportionate growth in the size of larger banks resulting from increased mergers and acquisitions (including some acquisitions of thrifts that had borrowed heavily from FHLBs, notably Washington Mutual, and reorganizations within bank holding companies). The bulk of these acquired advances were wound down in 2010 and 2011 when U.S. banks were rapidly reducing their use of non-deposit funding in general.

Although catalyzed by the unintended consequences of MMF reforms, the recent growth of banks’ borrowing from FHLBs was part of a broader transition to a funding structure less reliant on short-term non-deposit sources. The regulatory overhaul following the 2008 global financial crisis improved financial stability by making banks much less vulnerable to potential liquidity shocks than they were a decade ago. However, FHLBs now play a larger role in bank funding and have taken more of the maturity mismatch intrinsic to the function of the banking system onto their balance sheets. The reduction in systemic risk in the banking system came at a price: Private financial intermediaries are now even more interconnected with GSEs—and dependent on their public guarantees—than before the crisis.